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Buffett, who was probably the greatest investor of the 20th century,
is fond of quoting the salacious actress Mae West as saying, "Too
much of a good thing can be wonderful." In the market, such a motto
would lead you to avoid diversification and instead concentrate your
portfolio in stocks you really, really like.
Peter Lynch,
who was probably the best mutual fund manager of the 20th century,
calls spreading yourself too thin "diworseification."
Smart, witty
and brilliant at picking stocks, Buffett and Lynch may not need
diversification, but the rest of us do. When you own one stock,
you're out on a limb. For example, very few analysts — with
or without a conflict of interest — predicted that shares of
Enron, the energy and trading company, would tumble by 90% in a
year. Put all your eggs in a basket like that and you end up with
a gooey mess. The more stocks you own — as long as they are
in different industries — the more the overall riskiness of
your portfolio is modulated.
The reason
you don't want a super-risky portfolio is simple: While Warren Buffett
may be calm and prescient enough to ride out severe dips in the
value of his holdings, most investors are not. A portfolio that
increases in price by 10% each and every year is worth exactly the
same at the end of three years as a portfolio that falls by half
the first year, rises by three-quarters the second and rises by
52% the third. But reasonable investors prefer the consistent ride.
It prevents them from doing something stupid, such as selling all
their stocks after losing half their money during that first disastrous
year.
Consider the
sad case of James D. McCall, who earlier this month resigned as
manager of the Merrill Lynch Focus Twenty mutual fund. Two years
ago, Merrill wanted McCall's services so desperately that the firm
went to court to pry McCall away from his previous employer, Pilgrim
Baxter, where he rang up impressive gains in the late 1990s. (His
big success was called PBHG Large Cap 20.) And when they got McCall,
Merrill's brokers raised more than $1.5 billion from their clients
for him to invest. While the average growth-stock mutual fund owns
about 100 stocks, with the top-10 holdings representing about one-fourth
of the portfolio's total value, McCall specialized in what are called
"concentrated portfolios." In the case of Merrill Lynch Focus Twenty,
he owned, as the name implies, just 20 stocks. At last report, his
top-10 holdings accounted for a whopping two-thirds of the fund's
assets.
If McCall
had spread his 20 stocks among, say, a dozen different industries,
he might have smoothed his ride. Instead, 69% of his assets went
to technology firms. The Focus fund and a smaller one that McCall
ran called Premier Growth were launched in March 2000. Within just
17 months, all but $650 million of the clients' original $1.5 billion
had vanished.
It is hard
to imagine losing as much as Focus Twenty did even if you tried.
As of Nov. 9, the week McCall resigned, the fund was down 72% for
the year, compared with a loss of 14% for the Standard & Poor's
500-stock index, the benchmark for fund managers. According to the
latest report from Morningstar Mutual Funds, 19 of McCall's 20 stocks
had declined during 2001, the only exception being Harley-Davidson.
More amazing, 16 of the 19 losers had fallen by at least half. (By
the way, Enron was McCall's seventh-largest holding.)
"This fund
has had a wretched existence," wrote Morningstar analyst Kunal Kapoor,
who did admit a grudging admiration for McCall's perseverance. McCall's
"faith may turn out to be well placed over time," Kapoor said. Unfortunately,
time ran out.
My point here
is not to pick on McCall but to reveal the perils of concentration.
Buying Focus Twenty as a technology fund, and consigning it to no
more than one-fifth of your holdings (with the rest of your assets
in diversified, conventional stocks or funds) might have made sense,
but Focus Twenty was touted as a "long-term capital appreciation"
fund, not a sector fund. Here, it failed, but maybe it didn't have
to.
The manager
who made the concentrated fund popular, Tom Marsico, who ran Janus
Twenty, took care to spread his holdings around. His successor,
Scott Schoelzel, has suffered losses lately (he is down 28% year-to-date,
but that's after a total gain of 546% in the preceding five years),
but they have not been nearly so catastrophic — and for good
reason. Schoelzel's last report lists among his top 10 holdings
three tech stocks, two financials, one drug company, one energy
firm (whoops, Enron again), one industrial, one consumer-durables
company, and one services firm.
For investors
in individual stocks, the important question is this: How much diversification
is enough? Some risk is inherent in even the broadest portfolio.
This is called market, or "systematic," risk. Over the past 75 years,
market risk, as measured in standard deviation, has been about 20%.
In other words, in two-thirds of the years the annual return of
the S&P has fallen into a band ranging from 20 points lower to 20
points higher than its average return of 11%; that is, between a
loss of 9% and a gain of 31%. That's still volatile, but if you
invest in stocks you have to live with it.
What you don't
have to live with is anything more volatile. So your objective in
building a portfolio is to try to approximate systematic risk and
avoid what is called "idiosyncratic," or extra, risk. A portfolio
with just a few stocks, or one like McCall's, that is overloaded
in a single sector, has lots of idiosyncratic risk. In 1977, an
influential study found that investors could nearly eliminate that
extra risk by owning just 20 stocks in a wide variety of sectors;
in fact, owning eight or 10 stocks depressed risk sharply.
Recently,
however, the market has appeared to be far more volatile, and a
new study by a group of economists headed by John Campbell of Harvard
found that many more stocks were needed — around 50 —
to bring a portfolio down to the same level of riskiness as the
broad market. What Campbell's group found was that neither the market
itself nor individual sectors had become more volatile in the 1990s,
but that stocks within those sectors had, so you need to own more
of them.
But owning
50 stocks is a pain in the neck — and it brings up the Buffett-Lynch
admonitions about too much diversification. It is hard just to take
the time to make the selections, but even buy-and-hold investors
need to keep track of the companies they own to spot adverse changes
in management, product failures or new competition (not to mention
Enron-style accounting shenanigans) — signs that it's time
to sell.
One good answer
is to achieve balance by owning a combination of mutual funds and
stocks. For example, you might want to put 50% of the money you
have allotted for stocks into a fund that mimics the S&P itself,
like Vanguard Index 500, which charges rock-bottom expenses and
guarantees that risk won't exceed systematic levels. You could also
consider a broad fund that's managed by human beings, such as Meridian
Value or Baron Growth, which are recommended by Sheldon Jacobs,
editor of the No-Load Fund Investor newsletter. Then another 25%
of your holdings can go into a few sector funds that specialize
in technology, real estate, energy and small-caps, and the final
25% into a portfolio of 10 to 20 individual stocks. (I own 16, at
last count.)
There are
many valid variations. Just don't emulate Mark Twain.
In a letter
to clients recently, Anthony M. Maramarco, of David L. Babson &
Co., the Cambridge, Mass., investment firm, recalled the aphorism
of Twain's Pudd'n'head Wilson: "Put all your eggs in the one basket
— and watch that basket!" Unfortunately, such a philosophy
emphatically does not work in stock investing — as Twain himself
learned when he sank nearly all his fortune into the Paige Linotype,
a machine that flopped.
We all make
mistakes. (It was Twain, after all, who pointed out that "human
beings are the only animals that blush — or need to.") But
smart diversification helps investors avoid some of the worst of
them.
This
column originally appeared in the Washington Post.
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